RISK AND RETURN ANALYSIS

RETURN AND EXPECTED RETURNS

1. RETURNS
 Returns on an investment refer to the actual income earned or received from the investment,
combined with any change in the asset's market price, expressed as a percentage of the
opening market price.
 Returns serve as a measure of profitability and performance for an investment over a specific
period, typically expressed as a percentage. It reflects how well an investment has performed
considering both incomes generated and changes in its market value.
Formula for Returns:
The formula to calculate returns on an investment is:

EXAMPLE 1.
Andrew has invested in the shares of Z Plc. The price of the shares on 1 January is Tshs 3000,
dividend declared for the year is Tshs 200 and the year- end price on 31 December is Tshs 3500.
Calculate the rate of return.

EXAMPLE 2.
Let us consider an example for computing the returns on an investment made by Michael in the
securities of Strong Cements Plc. Michael purchased 2000 shares of par value Tshs 100 at a
market price of Tshs 2,500 per share. During the year, Strong Cements Plc declared a dividend
of 30 per cent, and the market price at the end of the year of the company’s security was Tshs
3,200.
What will be the returns earned by Michael on the investment in the shares of Strong Cements
Plc?

2. EXPECTED RETURNS
 Expected returns are the anticipated gains or losses from an investment, considering both the
potential returns and the likelihood of those returns occurring.
 These returns are estimated by considering the range of possible outcomes and their
respective probabilities.
 Expected returns serve as a crucial metric for investors, aiding in decision-making by
providing an average of potential outcomes. This metric considers not only the potential
gains or losses but also the probability of these occurrences.
So, what is the concept of Probability in Investment?
 Probability represents the likelihood or chance of an event occurring and is expressed as a
percentage between 0 and 1.
 A probability of 0 indicates an event is extremely unlikely, while a probability of 1 signifies
certainty.
 In the investment realm, probabilities are assigned to potential returns based on the likelihood
of those returns occurring. These probabilities help in estimating the overall expected return,
considering the chances of various outcomes.
 Example: If there's a 70% probability of a stock providing a 10% return and a 30%
probability of a 5% return, the expected return is calculated by considering both probabilities
in the weighted average.

What is the Expected Rate of Return?

 The expected rate of return is computed as the weighted average of all potential returns, each
multiplied by its corresponding probability.
 It is represented as the sum of (Return * Probability) for all potential outcomes.
 By multiplying each potential return by its respective probability and summing these
products, investors arrive at the expected rate of return. This calculation accounts for both the
range of possible outcomes and the likelihood of each outcome occurring.
This can be expressed as follows in the form of a formula:

EXAMPLE 3.
Given in the table below are expected rates of returns and their probabilities for investment made
in the securities of City Corporation Plc:

Find the expected rate of return

3. AVERAGE/MEAN RETURNS AND GEOMETRIC MEAN RETURNS
A. Average/Mean Returns:

 The average rate of return is calculated by summing the rates of return for individual periods
and dividing by the number of periods.
 This method provides a straightforward measure of the central tendency of returns over a
specified period, offering a quick assessment of overall performance.
 Example: Consider an investment with annual returns of 5%, 10%, and 15% over three years.
The average return would be (5% + 10% + 15%) / 3 = 10%.
B. Geometric Mean Returns:
Geometric Mean Returns incorporate compounding, assuming that dividend income received at
the end of each period is reinvested. The result is an annual compound rate known as the
Geometric Mean Return.
Geometric Mean considers the effect of compounding on investment returns, offering a more
accurate representation of the true growth rate over time.
EXAMPLE 4.
A invests Tshs 100 in XYZ Plc’s shares for 5 years. Rates of return (dividend) for the five years
are: 20%, 15%, 5%, 8% and -4%. Compute the geometric mean return for the shares held by A.
 RISK
 Risk is viewed as the likelihood or probability of experiencing an unfavorable outcome.
In finance, understanding the probability of a negative event is crucial for making informed
decisions. The higher the probability, the riskier the investment.
Example: Consider investing in a startup. If there's a high probability of the startup failing, the
investment carries a higher risk.

 Also, risk is also seen as the variability between actual returns and the expected returns of a
given asset, reflecting uncertainty in outcomes.
This definition captures the idea that even if an investment has a certain expected return, the
actual return may deviate, introducing risk.

The two aspects of risk are Probability and Potential Loss

 Risk encompasses two key aspects - the probability of occurrence of a loss and the potential
magnitude of that loss.
 Assessing risk involves not only evaluating how likely an adverse event is but also
considering the potential severity of the impact if the event occurs.
 Example: In the context of project management, the risk of a project delay involves both the
likelihood of delays occurring (probability) and the extent of the delay's impact on the
project's timeline (potential loss).

MEASURING RISK
The risk in relation to a single asset is measured with respect to (i) behavioral and (ii)
quantitative or statistical point of view.
I. Behavioral assessment of risk
There are two techniques for behavioral assessment of risk:
(a) Sensitivity analysis
(b) Probability analysis

a. Sensitivity analysis
 This technique considers the various possible estimates of outcomes for assessing the risk. It
takes into consideration the worst (recession in economy), the most likely (normal conditions
in the economy) and the most optimistic outcome (boom) associated with the asset under
consideration. The difference between the worst outcome and the most optimistic outcome is
referred to as the range. Range is the basic measure of risk according to the sensitivity
analysis technique. The higher the range, the higher is the risk to which the asset/ investment
is exposed.
EXAMPLE 5
Given below are details of expected returns from two assets of a company:

Asset 1 has a higher range, which means that asset 1 is riskier than asset 2.
b. Probability Analysis:
 Assesses risk with a more accurate approach than Sensitivity Analysis by considering the
likelihood or chance of an event occurring.
 Probability Analysis provides a quantitative measure of risk, considering the probability
distribution of various outcomes.

II. Quantitative or statistical analysis of risk

(a) Standard deviation
(b) Coefficient of variation
a. Standard deviation
 Standard Deviation is a widely used measure of risk in finance. It quantifies the extent of
variability or dispersion of returns from the expected value.
 Investors and analysts utilize standard deviation to assess the level of uncertainty or risk
associated with an investment.
Calculation Formula:

 This formula captures the differences between individual returns (Ri) and the expected return
(R), weighted by their respective probabilities (Pi). The square of the differences is summed
up, divided by the number of possible outcomes (n), and then the square root is taken.
Where;
(Rˉ) = Expected Return, the anticipated or most likely return from the investment.
(Ri) = Individual Return, the return for a specific outcome or scenario.
(Pi) = Probability, the likelihood of each outcome occurring.
(n) = Number of Possible Outcomes, the total number of different scenarios or possibilities.
A higher standard deviation indicates greater variability in returns, representing higher risk.
b. Coefficient of Variation
 The Coefficient of Variation is a financial metric used to measure the risk per unit of
expected return. It's particularly valuable for comparing the risk of assets or investments with
different expected returns.
 Investors often seek a balance between risk and return. CV provides a standardized way to
evaluate risk relative to expected return, facilitating comparisons across diverse assets.
Formula for Coefficient of Variation (CV):

The greater the coefficient of variation, the greater is the risk for the asset/ investment.

EXAMPLE 5.
Given below are details of expected returns and the probabilities for asset 1.

calculate the
a. standard deviation
b. coefficient of variation

EXAMPLE 6.
Following table gives information relating to rate of return and probability distribution of shares
of Tasty Foods Plc:

Required:
Calculate variance, standard deviation and Coefficient of variation of returns for Tasty Foods
Plc.